Compatibility Between Monetary and Fiscal Policy Under EMU
The potential importance of fiscal policy in influencing inflation has recently been highlighted, following Woodford (1998), under the heading of the ‘Fiscal Theory of the Price Level’ (FTPL). Some authors have suggested that this theory provides a rationale for the Pact for Stability and Growth as a necessary condition for the ECB pursuing a policy of price stability. In this paper, we relax the assumptions underpinning the FTPL by developing a two country open economy model, where each country has overlapping generations of non-Ricardian consumers who supply labour to imperfectly competitive firms which can only change their prices infrequently. We examine the case where the two countries have formed a monetary union, but where the fiscal authorities remain independent. We show that the fiscal response required to ensure solvency is greater when consumers are not infinitely lived, and that although this allows for some compensating behaviour between governments, in general, both fiscal policies must remain solvent if the ECB is to aggressively target inflation. We also show that the monetary authority can abandon its active targeting of inflation to ensure the solvency of at most one fiscal authority. Any other combination of policies will either result in price level indeterminacy and/or indefinite transfers of wealth between the two economies. Finally, in a series of simulations we show that fiscal shocks have limited impact on output and inflation provided the fiscal authorities meet the (weak) requirements of fiscal solvency. However, when monetary policy is forced to abandon its active targeting of inflation, then fiscal shocks have a much greater impact on both output and inflation.
|Date of creation:|
|Date of revision:|
|Contact details of provider:|| Postal: |
Phone: 0141 330 4618
Fax: 0141 330 4940
Web page: http://www.gla.ac.uk/schools/business/research/
More information through EDIRC
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Julio J. Rotemberg & Michael Woodford, 1998. "An Optimization-Based Econometric Framework for the Evaluation of Monetary Policy: Expanded Version," NBER Technical Working Papers 0233, National Bureau of Economic Research, Inc.
- C.A. Sims, 1999. "The Precarious Fiscal Foundations of EMU," DNB Staff Reports (discontinued) 34, Netherlands Central Bank.
- Erceg, Christopher J. & Henderson, Dale W. & Levin, Andrew T., 2000.
"Optimal monetary policy with staggered wage and price contracts,"
Journal of Monetary Economics,
Elsevier, vol. 46(2), pages 281-313, October.
- Christopher J. Erceg & Dale W. Henderson & Andrew T. Levin, 1999. "Optimal monetary policy with staggered wage and price contracts," International Finance Discussion Papers 640, Board of Governors of the Federal Reserve System (U.S.).
- Ryo Kato & Takayuki Tsuruga, 2002. "Matlab code for a sticky wage/price model," QM&RBC Codes 114, Quantitative Macroeconomics & Real Business Cycles.
- Tom Doan, . "RATS program to solve Erceg-Henderson-Levin model," Statistical Software Components RTZ00051, Boston College Department of Economics.
- Andrew Levin & Christopher J. Erceg & Dale W. Henderson, 1999. "Optimal Monetary Policy with Staggered Wage and Price Contracts," Computing in Economics and Finance 1999 1151, Society for Computational Economics.
- Galí, Jordi & Gertler, Mark & López-Salido, J David, 2001.
"European Inflation Dynamics,"
CEPR Discussion Papers
2684, C.E.P.R. Discussion Papers.
- Obstfeld, Maurice & Rogoff, Kenneth S., 1995.
"Exchange Rate Dynamics Redux,"
12491026, Harvard University Department of Economics.
- Maurice Obstfeld and Kenneth Rogoff., 1995. "Exchange Rate Dynamics Redux," Center for International and Development Economics Research (CIDER) Working Papers C95-048, University of California at Berkeley.
- Maurice Obstfeld & Kenneth Rogoff, 1994. "Exchange Rate Dynamics Redux," NBER Working Papers 4693, National Bureau of Economic Research, Inc.
- Obstfeld, Maurice & Rogoff, Kenneth, 1995. "Exchange Rate Dynamics Redux," CEPR Discussion Papers 1131, C.E.P.R. Discussion Papers.
- Gali, Jordi, 1994. "Government size and macroeconomic stability," European Economic Review, Elsevier, vol. 38(1), pages 117-132, January.
- Marvin Goodfriend & Robert King, 1997.
"The New Neoclassical Synthesis and the Role of Monetary Policy,"
in: NBER Macroeconomics Annual 1997, Volume 12, pages 231-296
National Bureau of Economic Research, Inc.
- Marvin Goodfriend & Robert G. King, 1998. "The new neoclassical synthesis and the role of monetary policy," Working Paper 98-05, Federal Reserve Bank of Richmond.
- Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
- Canzoneri, Matthew B & Cumby, Robert E & Diba, Behzad T, 2001. "Fiscal Discipline and Exchange Rate Systems," Economic Journal, Royal Economic Society, vol. 111(474), pages 667-90, October.
- Leith, Campbell & Wren-Lewis, Simon, 2000. "Interactions between Monetary and Fiscal Policy Rules," Economic Journal, Royal Economic Society, vol. 110(462), pages C93-108, March.
- Dupor, Bill, 2000. "Exchange rates and the fiscal theory of the price level," Journal of Monetary Economics, Elsevier, vol. 45(3), pages 613-630, June.
- Michael Woodford, 1995.
"Price Level Determinacy Without Control of a Monetary Aggregate,"
NBER Working Papers
5204, National Bureau of Economic Research, Inc.
- Woodford, Michael, 1995. "Price-level determinacy without control of a monetary aggregate," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 43(1), pages 1-46, December.
- John H. Cochrane, 1998.
"A Frictionless View of U.S. Inflation,"
CRSP working papers
479, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
- Michael Woodford, 1996. "Control of the Public Debt: A Requirement for Price Stability?," NBER Working Papers 5684, National Bureau of Economic Research, Inc.
- Barro, Robert J, 1979.
"On the Determination of the Public Debt,"
Journal of Political Economy,
University of Chicago Press, vol. 87(5), pages 940-71, October.
- Matthew B. Canzoneri & Robert E. Cumby & Behzad T. Diba, 2001.
"Is the Price Level Determined by the Needs of Fiscal Solvency?,"
American Economic Review,
American Economic Association, vol. 91(5), pages 1221-1238, December.
- Matthew B. Canzoneri & Robert E. Cumby & Behzad T. Diba, 1998. "Is the Price Level Determined by the Needs of Fiscal Solvency?," NBER Working Papers 6471, National Bureau of Economic Research, Inc.
- Canzoneri, Matthew B & Cumby, Robert & Diba, Behzad, 1998. "Is the Price Level Determined by the Needs of Fiscal Solvency?," CEPR Discussion Papers 1772, C.E.P.R. Discussion Papers.
- Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
- Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall.
- Leith, Campbell & Malley, Jim, 2005.
"Estimated general equilibrium models for the evaluation of monetary policy in the US and Europe,"
European Economic Review,
Elsevier, vol. 49(8), pages 2137-2159, November.
- Campbell Leith & Jim Malley, 2002. "Estimated General Equilibrium Models for the Evaluation of Monetary Policy in the US and Europe," CESifo Working Paper Series 699, CESifo Group Munich.
- Campbell leith & Jim Malley, 2002. "Estimated General Equilibrium Models for the Evaluation of Monetary Policy in the US and Europe," Working Papers 2001_16, Business School - Economics, University of Glasgow.
- Leeper, Eric M., 1991. "Equilibria under 'active' and 'passive' monetary and fiscal policies," Journal of Monetary Economics, Elsevier, vol. 27(1), pages 129-147, February.
- Bergin, Paul R., 2000. "Fiscal solvency and price level determination in a monetary union," Journal of Monetary Economics, Elsevier, vol. 45(1), pages 37-53, February.
- Anil K Kashyap, 1995. "Sticky Prices: New Evidence from Retail Catalogs," The Quarterly Journal of Economics, Oxford University Press, vol. 110(1), pages 245-274.
- Daniel, Betty C., 2001. "The fiscal theory of the price level in an open economy," Journal of Monetary Economics, Elsevier, vol. 48(2), pages 293-308, October.
- Steven A. Symansky & Douglas Laxton & Hamid Faruqee, 1996.
"Government Debt, Life-Cycle Income and Liquidity Constrains: Beyond Approximate Ricardian Equivalence,"
IMF Working Papers
96/140, International Monetary Fund.
- Hamid Faruqee & Douglas Laxton & Steven Symansky, 1997. "Government Debt, Life-Cycle Income, and Liquidity Constraints: Beyond Approximate Ricardian Equivalence," IMF Staff Papers, Palgrave Macmillan, vol. 44(3), pages 374-382, September.
When requesting a correction, please mention this item's handle: RePEc:gla:glaewp:2001_15. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Jeanette Findlay)
If references are entirely missing, you can add them using this form.